Why Does An Economy Need Derivatives?

 

There are downsides to derivatives - such as speculators assuming larger risks than they should - but that's a personal choice.

An economy still needs derivatives for multiple positive reasons, such as:

1. To help producers and consumers hedge themselves against market volatility.

For examples, derivatives like futures contracts let farmers be assured of minimum prices when their produce reaches the market.

2. To provide investors more options for intelligent bets.

For example, Benjamin Graham, Warren Buffett and most other successful investors have always taught that one makes money consistently only from long term investments.

But without derivatives, the only way to make a long term investments is to buy an undervalued stock or commodity. The market consists of equal number of overvalued stocks and commodities. Without derivatives, there would be no way to make long term investments by betting against them.

The derivatives Warren Buffett invested in in 2009 all had expiration dates of 10-20 years.

3. Reducing the potential for loss.

The potential for loss in short selling is theoretically infinite. But one can use a derivative "option" to make the same kind of bet while limiting one's potential for loss to the cost of the option.

4. For the same reason that an economy needs day trading and short selling - to keep the market liquid and reduce the price spreads.

Derivatives help keep the market more liquid, so that one can be assured of more consistent behavior in prices when making large trades.

Without frequent market movement - as can be seen in the case of instruments with low liquidity - there are often large differences between bid and ask prices; and even between prices for small and large trades.